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The Next Wave of Ethanol Offtake Agreements

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Written by Stan Wendzel MBA, CPA, LEED AP   


A key part of any ethanol project is the agreement that governs the purchase of the ethanol that is produced. These agreements commonly referred to as “offtakes”, “offtake agreements”, or “marketing agreements” can significantly influence a plant’s profitability. Typically, these agreements are of a “take or pay” nature requiring the offtaker to purchase all of the ethanol that is produced, and from a pricing perspective, these agreements have historically been based upon the spot market for ethanol at the time of production. While these arrangements do provide a producer comfort that his ethanol output will be sold, producers still face significant price risk.



To get a sense of why price risk is important let’s review the recent market for ethanol and corn. For producers watching these markets between May 2005 and June 2006, price risk with respect to ethanol sales may not have been a grave concern. In May 2005 ethanol spot prices hovered around $1.15 per gallon. A year later, prices were breaking the $4.00 mark, nearly a 250% increase in 14 months. With offtakes based upon spot prices, producers were reaping tremendous profits. But commodity price volatility works both ways. By October 2006, prices moderated to under $2.00 per gallon…and front month contracts for corn were suddenly above $3.00 per bushel. Price risk once again becomes front and center for producers who need to protect profit margins.

The Next Wave:
It is no wonder then why we are starting to see a wave of offtake agreements which are different from those of the past. One variation that is beginning to come into favor is an agreement where the gross margin on ethanol production is protected. Called a “Fixed Margin Offtake” or “FMO”, these agreements can extend for a period of five years or more, significantly changing the risk profile for the producer in its early years.

Typically corn and natural gas account for 80 to 85% of the costs and ethanol accounts for 80 to 85% of the revenues associated with producing ethanol. The basic premise with Fixed Margin Offtakes is to lock in the margin between the price of ethanol and the cost of corn and natural gas (the “Gross Margin”), thereby protecting plant profitability. This type of agreement is analogous to a tolling arrangement which is used frequently in the power industry.

The value of a FMO is significant given the lack of historic price relationship between corn, natural gas, and ethanol and the inability to hedge all three commodities on a long term basis. Market data shows that in the past these three commodities have been highly volatile and highly uncorrelated with one another. Moreover, the current futures market for ethanol allows one to hedge prices no more than about 15 to 18 months in advance. The result is without a Fixed Margin Offtake you cannot be assured of long term plant profitability. Profitability for an ethanol producer can be terrific one month and negative a few months later.

The FMO allows producers a mechanism to effectively hedge both their primary inputs as well as their primary outputs, creating a margin lock and stabilizing the plant’s profitability. Such protection of margin can create a significant advantage for the producer, not just for stabilizing cash flow, but also when considering various lending options for financing their plant.

Benefits:
The ability to lock in Gross Margins and avoid this substantial profit volatility for five years or more allows a producer to achieve much better financing terms. Our firm has projects where the advance rate, term of financing, and interest rate were all improved by having a FMO. For example:

  Senior Loan Subordinate Loan
Loan to Cost (advance rate) 70% 15%
Term of Loan 10 years 10 years
Interest Rate LIBOR + 300 bps Low teens
Cash Flow Sweeps None None



We believe these terms compare favorably to a typical project, which relies on a traditional offtake arrangement based on spot prices rather than a FMO.

In addition to improved loan terms perhaps the biggest benefit of a Fixed Margin Offtake is the reduced dilution of equity ownership. If an ethanol producer is able to achieve 80-85% of the necessary financing for a project via debt, the amount of equity and therefore ownership required from outside investors is substantially reduced. In fact, compared to a traditional ethanol project the equity dilution can be reduced in half. The FMO can provide the equity owners an ability to increase the debt financing without substantially changing their risk profile. This can be very attractive to producers who wish to be “less aggressive” with their project financing approach.

Beyond the improved loan terms and reduced equity dilution, a FMO can accelerate speed to market. The bottleneck for most ethanol projects today is closing the debt and equity capital raises. A FMO expedites the debt financing as most ethanol lenders are actively seeking the few projects with this type of offtake arrangement and are prioritizing those project due to the reduced risk profile; likewise, reducing the amount of third party equity results in a faster equity raise in most instances.

With about thirty five ethanol products currently under construction or expansion in the U.S. and at least half seeking third party equity, there is an abundance of projects in the market for investors to choose from. Selectivity is good from the investors’ standpoint; and it requires that producers differentiate their projects to stand out from others. Having a FMO in place provides this differentiation, can make the project more attractive to investors, and accelerates the financing process.

Why Aren’t FMOs Used More?
With all these benefits why aren’t more projects being financed this way? Two primary reasons are relationships and expectations. First, to obtain a Fixed Margin Offtake you must have the relationships with someone at a major oil company, blender or refiner that is in need of ethanol. The relationship must be with an individual or group that not only is responsible for securing ethanol offtakes, but also is open-minded to this non-traditional form of offtake. The second reason, expectations, involves a misconception on the part of ethanol producers as to the expected pricing for a FMO. Producers must realize the benefits of protecting margin and not get caught up in dreaming about $4.00 ethanol and $2.00 corn.

Pricing an FMO:
To estimate FMO pricing one only has to visit the CBOT and NYMEX websites and see the most long dated future prices of corn, natural gas and ethanol. Because of the infancy of ethanol futures the farthest one can go out using this approach is about 15 to 18 months; however this is enough to give us a rough approximation of how a Fixed Margin Offtake should be priced.

For example as of 10/6/06 the December 2007 futures prices are as follows:

Ethanol (per gallon) $1.70
Corn (per bushel) $3.04
Natural Gas (per MMBTU) $9.06



Now there are a number of ways to structure a FMO but perhaps the simplest is a formula where the price of ethanol is derived as follows:

Ethanol Price = (Corn Price / 2.8) + (Natural Gas / 30) + Gross Margin

 

Note the 2.8 factor is the typical relationship between ethanol (per gallon) to corn (per bushel) and the 30 factor is the typical relationship between ethanol (per gallon) to natural gas (per mmBtu).


Using this formula and solving for Gross Margin we calculate that the Gross Margin should be 31 cents based upon current December 2007 futures prices, but remember this would be if we locked in our margin for only 15 months.

What does all this mean?
Producers insisting on locking a gross margin of $1 per gallon using a FMO will have a hard time given today’s futures markets.

If you are interesting in a Fixed Margin Offtake but insisting on a Gross Margin of $1 per gallon that’s simply not consistent with what a highly developed futures market tells us today. There is a big difference between knowing your profits for the next five years versus being highly profitable today but having no idea if you will make any profit a few months down the road.

Why then do some ethanol producers expect a $0.50 to $1 per gallon Gross Margin today when considering a Fixed Margin Offtake? The answer is they either totally disregarding the current futures market or they greatly underestimate the value of locking in Gross Margins for five years, or both. Producers are essentially transferring a significant risk and must appreciate the economics to make such an agreement work for all parties. In return, they will know their profits will be stable over the next five years, and will eliminate the peaks and valleys synonymous with spot pricing.

Selecting a FMO is analogous to choosing a fixed rate mortgage over an adjustable. For those choosing adjustables the going has been great while interest rates remained low - but some know that won’t last forever. Perhaps ethanol producers will have to actually face sustained lower margins before they recognize the value of locking in profits long term.

When you combine the protected long-term profitability with the numerous other benefits of a Fixed Margin Offtake, we think the FMO usually wins out, but please don’t accept that as an endorsement to always enter a FMO, as each situation and client are unique. However, if you are considering a Fixed Margin Offtake please take into account the current pricing in the futures market and make sure you do an objective comparison without the rose colored glasses of $4.00 ethanol and $2.30 corn. The recent past’s unusually high profitability for ethanol producers is unlikely to be repeated in the future.

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